Tag Archives | exchange rates

The Murky Connections between Trade and Exchange Rate

A positive trade balance should result in appreciation of the currency. However, it is in the interest of countries that export large volumes of goods to have a weaker currency.

By Shobitha Cherian and Anupam Manur

The relationship between the strength of an economy and the strength of the currency was discussed in a previous post. The aim of this post is to discuss the conditions under which economies would want to have a weaker currency. Generally, it is in the interest of countries that export large volumes of goods to have a weaker currency.

The exchange rate of a particular currency is determined mainly by the demand and supply of the said currency. By this logic, countries which export large volumes of goods, or which have higher international demand for their goods, would have stronger currencies, or would have a higher value when compared to the reserve currency or the U.S Dollar. This is due to the fact that since their goods are high in demand, so will be their currency. However, in actual practice, one can see that it is favourable for certain countries to have weaker currencies.

Table showing the relationship between trade balance and exchange rates

Table showing the relationship between trade balance and exchange rates

Source: Calculations based on data from World trade organisation and the International monetary fund database.  Note: Since the countries belonging to the Euro zone use a common currency, they have been eliminated from this analysis.

The above set of countries shows the volume of exports as a percentage share of total world exports, the current account balance (difference between exports and imports) and their exchange rate with respect to the US$. The chosen countries are amongst the top 20 exporters.

From the above data set, it is apparent that countries with a significant share of the world export market have currencies that are weaker than the dollar, i.e., more of that currency is required to buy one dollar. The Korean Won and more so the Indonesia rupiah stand out; around 12800 rupiah is required to buy 1US$.

However, merely looking at export data and the exchange rate gives an incomplete picture. Since the exchange rate is determined by a country’s exports and imports, the relevant data to look at is the trade balance (second column). Further, the strength of a currency has to be looked at in terms of changes. The third column gives the percentage change in the value of the currency since 2010 (a positive number reflects appreciation and a negative number means that the currency has depreciated/weakened).

The table above shows the rather murky lines between economic principles and reality. As explained above, a positive trade balance should result in a currency appreciation and vice versa. Only five of ten countries (highlighted in green) follow this rule. Saudi Arabia and the UAE have fixed exchange rate regimes and thus, show no change in the five years despite having a positive trade balance. Japan, Russia and South Korea have very strong trade surpluses, yet their currencies have depreciated during this period. The Russian rouble has depreciated by over 175%.

Why is this so?

The regulatory authorities of a country may actively keep their currency weak in order to boost exports; if the currency is weaker, the goods produced domestically for export become cheaper for the rest of the world, and by the simple principle of demand and supply, the demand for its goods increases.

Monetary authorities achieve this using a variety of instruments at their disposal. It can impose foreign exchange controls – artificially restrict the movement of the currency. The central banks also participate in the foreign exchange markets to keep the currency at the desired level. For example, if the rupee begins to appreciate against the dollar, RBI steps in, sells rupees and buy dollars, which will devalue the rupee.

Devaluation is sometimes used deliberately as a policy action in times of contraction, where the country would want to get back to the growth path through exports. However, continued devaluation can be seen as a manipulative path of action which seeks to keep a currency artificially weak and will usually face outrage by the international community. This might also result in a competitive devaluation amongst competitors, which can have grave consequences for global financial stability.

Shobitha Cherian is an intern at Takshashila Institution and studies B.Sc economics at Christ University

Anupam Manur is a policy analyst at Takshashila Institution and tweets @anupammanur

 

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Does a strong currency mean a strong economy?

by Anupam Manur & Varun Ramachandra

Exchange rates have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

In their book The Dollar Crisis, Paul Simon and Ross Perot famously said that “A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation”. The quote was mentioned in the larger context of American military and economic might, but the feelings espoused in the quote are shared by many. For instance, this article in the Economist describes the feeling of despair amongst the citizens of Hong Kong when the value of their currency (Hong Kong dollar) slipped below that of Mainland China (Yuan). Politicians, central bankers, economists, and policy makers often share the ‘blame’ for a weak currency. But is a ‘weak’ currency truly an indicator of a ‘weak’ economy? Consequently does a ‘strong’ currency necessarily imply a ‘strong’ economy? This post aims to answer these questions.

The strength of a currency, in economic terms, implies the price (or the exchange rate) of one currency in terms of another foreign currency; this is usually measured with respect to the US Dollar, which is considered as the world’s reserve currency. (We will discuss why the US dollar is the world’s reserve currency in our next post). An exchange rate higher than one implies that the currency is stronger than the dollar and an exchange rate lesser than one implies that it is weaker.

The strength of an economy is measured by various means and the most used measure is the value of its Gross Domestic Product (or GDP).  The GDP measures the level of economic activity within a country and is the final monetary value of all the finished goods and services produced. It is a comprehensive measure of economic strength of a country[1]. The table below illustrates the metrics discussed thus far.

ExchangeRateGDP

Source: GDP, GDP per capita and the ranks from IMF database. Exchange rate is obtained from IMF and XE.com

Note on exchange rate rank:  It is obtained by sorting, in ascending order, the dollar value of domestic currencies. This is a metric derived purely for understanding the ideas discussed in this post and is not a robust measure.

Note on US$, per unit: This number indicates the number of US dollars that can be bought using the domestic currency. Example, exchange rate of 0.0160 for India means that one Indian rupee can buy 0.016 US dollars.

It is clear from the table that China, India and Japan are the second, third and fourth largest economies in the world, but their currencies are relatively weak. In fact, the per-capita GDP and exchange rates are also not comparable variables.

EXCHANGE RATE DETERMINATION

According to economics textbooks, the exchange rate is determined by the demand and supply for a currency relative to another foreign currency. This exchange rate arises out of three major factors:

First, the demand for a currency comes from people acquiring more of a particular currency to pay for foreign goods that they wish to buy (imports). Therefore, the exchange rate is determined by the volume of exports and imports of a country. If a country exports more than it imports, the demand for the exporter country’s currency and its exchange rate rises. Generally, an exporting country would want all or some of its payments made to it in its local currency, which would increase the demand for its currency.

Second, the demand for currencies arises from the financial markets and interest rate regimes. London is the one of the biggest financial centres — measured in terms of the volume of foreign exchange turnover– in the world and hence there is high demand for the Pound Sterling, as is the case with Swiss Francs. Further, countries with higher interest rates normally tend to have stronger currencies, as investors hope to get higher returns on their investments. A high interest regime encourages conversion into these local currencies and helps attain larger returns.

Third, it is in the interest of certain countries to have a weaker currency. A weaker currency will make exports cheaper and imports expensive giving these countries a competitive edge in the world market. Thus, the central banks and governments of different countries deliberately try to have a weaker currency.

The three factors discussed are not comprehensive and do not possess equal weightage; the eventual exchange rate dynamics depends on several other parameters.

Market determination of exchange rate does completely explain the exchange rate determination. There are more exceptions to this than adherents. For example, the Bahamian Dollar is exactly on par with the US dollar, despite playing a negligible role in world trade. This is due to the fact that the central bank of Bahamas has artificially pegged its currency 1:1 with the US dollar. That is even an infinitesimal change in the US dollar is directly reflected in the Bahamian dollar. Currency pegging (either 1:1 or some other predetermined ratio) is done by many countries to maintain stability. For example, Nepal and Bhutan have pegged their currency to the Indian rupee.

In conclusion, it is flippant to estimate the strength of an economy solely through the value of a currency. The strength of an economy is dependent on several variables that exhibit multi-causal relationship amongst themselves. Exchange rate have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

 

[1] For simplicity, this post considers the GDP as the measure of strength of economy; to eliminate large country/ population bias we must consider the per-capita GDP (total GDP divided by the population) to arrive at a precise figure. Countries like India rank high in terms of GDP but, thanks to its population, rank much lower in per-capita GDP. Kuwait, on the other hand, ranks high in terms of per-capita GDP.

Anupam Manur is a Policy Analyst at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale

 

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